Friday, May 13, 2011

In April the CPI registered a 3.2% rise over the past 12 months, a 5.1% annualized rise over the past six months, and a 6.2% annualized rise over the past 3 months. The bond market and the Fed appear to be ignoring that, in the belief that it is mainly due to energy prices, and those have already cooled in recent weeks, so perhaps this is only a transitory rise in inflation.

But as this chart shows, the core CPI (ex food & energy) is up 1.3% over the past 12 months. Moreover, it is up at an annualized rate of 1.8% in the past six months, and a 2.1% annualized rate in the past three months. It's not so easy to dismiss the recent rise in inflation as transitory. If we just look at the CPI ex-energy, it is up 1.6% in the past 12 months, and has risen at an annualized rate of 2.3% in the past six months and 2.9% in the past three months. Inflation is heating up, no matter how you slice and dice the numbers, and the pickup appears to be broad-based.

This chart also suggests that the bond market is on shaky ground, since inflation is the most important determinant of yields. The core CPI will almost certainly approach 2% on a year over year basis in coming months, and could well exceed that level before the year is out. The last time the core CPI was 2%, bond yields were substantially higher than they are today. The bond market is ignoring the rise in inflation for now, in the belief that economic weakness makes it only a temporary phenomenon, but that belief is going to be tested in coming months. From my perspective, I see no reason for core inflation to decline, so I think there is a good chance that Treasury yields are going to rise.

Interesting question: As you know, many economists suggest the CPI overstates inflation. Mark Perry cites studies that people want $1000 today to buy today's good vs $1000 to buy 1980s goods. That's how much product quality has improved. (I may have the dates off, the gist is correct).

Let us argue that yes, the CPI overstates inflation. The bond market senses that and thus Treasury yields are "below" where they should be, if we rely on the CPI.

Add in plenty of global capital supply, and you get a market that brings to us interest rates that seem low.